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4 Depreciation, the trade balance and output
Chapter 18 The goods market in an open economy 377
The relative price of foreign goods in terms of domestic goods, 1/e, increases. This increases
the import bill, IM/e. The same quantity of imports now costs more to buy (in terms of
For the trade balance to improve following a depreciation, exports must increase enough
and imports must decrease enough to compensate for the increase in the price of imports. The
condition under which a real depreciation leads to an increase in net exports is known as the
Marshall–Lerner condition. (It is derived formally in the appendix at the end of this chapter.) ➤ It is named after the two economists,
Alfred Marshall and Abba Lerner, who
It turns out – with a complication we will state when we introduce dynamics later in this chapwere the first to derive it.
ter – that this condition is satisfied in reality. So, for the rest of this text, we shall assume that
a real depreciation – a decrease in e – leads to an increase in net exports – an increase in NX.
The effects of a real depreciation
We have looked so far at the direct effects of a depreciation on the trade balance – that is,
the effects given UK and foreign output. But the effects do not end there. The change in net
exports changes domestic output, which affects net exports further.
Because the effects of a real depreciation are much like those of an increase in foreign
output, we can use Figure 18.4, the same figure that we used previously to show the effects
of an increase in foreign output.
Just like an increase in foreign output, a depreciation leads to an increase in net exports
(assuming, as we do, that the Marshall–Lerner condition holds), at any level of output.
Both the demand relation (ZZ in Figure 18.4(a)) and the net exports relation (NX in
Figure 18.4(b)) shift up. The equilibrium moves from A to A′ and output increases from Y
to Y′. By the same argument we used previously, the trade balance improves. The increase
in imports induced by the increase in output is smaller than the direct improvement in the
trade balance induced by the depreciation.
Let’s summarise. The depreciation leads to a shift in demand, both foreign and domestic,
towards domestic goods. This shift in demand leads, in turn, to both an increase in domestic
output and an improvement in the trade balance.
Although a depreciation and an increase in foreign output have the same effect on domestic output and the trade balance, there is a subtle but important difference between the two.
A depreciation works by making foreign goods relatively more expensive. But this means that,
for a given income, people – who now have to pay more to buy foreign goods because of the
depreciation – are worse off. This mechanism is strongly felt in countries that go through a
large depreciation. Governments trying to achieve a large depreciation often find themselves
with strikes and riots in the streets, as people react to the much higher prices of imported
goods. This was the case in Mexico, for example, where the large depreciation of the peso in
1994–1995 – from 29 cents per peso in November 1994 to 17 cents per peso in May 1995 –
led to a large decline in workers’ living standards and to social unrest.
There is an alternative to riots – asking
for and obtaining an increase in wages.
But, if wages increase, the prices of
domestic goods will follow and increase
as well, leading to a smaller real depreciation. To discuss this mechanism,
we need to look at the supply side in
more detail than we have done so far.
We shall return later to the dynamics
of depreciation, wage and price movements (in Chapter 20).
Combining exchange rate and fiscal policies
Suppose output is at its natural level, but the economy is running a large trade deficit. The
government would like to reduce the trade deficit while leaving output unchanged, so as to
avoid overheating. What should it do?
A depreciation alone will not do. It will reduce the trade deficit, but it will also increase
output. Nor will a fiscal contraction do. It will reduce the trade deficit, but it will decrease
output. What should the government do? The answer: use the right combination of depreciation and fiscal contraction. Figure 18.5 shows what this combination should be.
Suppose the initial equilibrium in Figure 18.6(a) is at A, associated with output Y. At this
level of output, there is a trade deficit, given by the distance BC in Figure 18.6(b). If the government wants to eliminate the trade deficit without changing output, it must do two things.
It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of
output. So the depreciation must be such as to shift the net exports relation from NX to NX′
M18 Macroeconomics 85678.indd 377
378 EXTENSIONS The open economy
≤NX > 0
To reduce the trade deficit without
changing output, the government
must both achieve a depreciation and
decrease government spending.
Net exports, NX
Reducing the trade deficit
without changing output
≤G < 0
≤NX > 0
in Figure 18.6(b). The problem is that this depreciation, and the associated increase in net
exports, also shifts the demand relation in Figure 18.6(a) from ZZ to ZZ′. In the absence
of other measures, the equilibrium would move from A to A′, and output would increase
from Y to Y′.
To avoid the increase in output, the government must reduce government spending so as
to shift ZZ′ back to ZZ. This combination of a depreciation and a fiscal contraction leads
to the same level of output and an improved trade balance.
There is a general point behind this example. To the extent that governments care about
both the level of output and the trade balance, they have to use both fiscal policy and exchange
rate policies. We just saw one such combination. Table 18.1 gives you others, depending on
the initial output and trade situation. Take, for example, the cell in the top right corner of the
table: initial output is too low (put another way, unemployment is too high) and the economy
has a trade deficit. A depreciation will help on both the trade and the output fronts. It reduces
the trade deficit and increases output. But there is no reason for the depreciation to achieve
both the correct increase in output and the elimination of the trade deficit. Depending on
the initial situation and the relative effects of the depreciation on output and the trade balance, the government may need to complement the depreciation with either an increase
A general lesson: if you want to achieve
or a decrease in government spending. This ambiguity is captured by the question mark in
two targets (here, output and trade balance), you better have two instruments ➤ the cell. Make sure that you understand the logic behind each of the other three cells. (For
(here, fiscal policy and the exchange
another example of the role of the real exchange rate and output in affecting the current
account balance, look at the next Focus box.)
Table 18.1 Exchange rate and fiscal policy combinations
M18 Macroeconomics 85678.indd 378
e T g?
e c g?
Chapter 18 The goods market in an open economy 379
The disappearance of current account deficits in euro periphery
countries: good news or bad news?
Starting in the early 2000s, a number of euro periphery
countries ran larger and larger current account deficits.
Figure 18.6 shows the evolution of the current account
balances of Spain, Portugal and Greece, from 2000 on.
Although the deficits were already substantial in 2000,
they continued to increase, reaching 9% of GDP for Spain,
12% for Portugal and 14% for Greece by 2008.
When the crisis started in 2008, those three countries
found it increasingly difficult to borrow abroad, forcing
them to reduce borrowing and thus to reduce their current
account deficits. And reduce they did. Figure 18.7 shows
that, by 2013, the deficits had turned into surpluses in all
It is an impressive turnaround. Is it unambiguously
good news? Not necessarily. The discussion in the text
suggests that there are two reasons why a current account
may improve. The first is that the country becomes more
competitive. The real exchange rate decreases. Exports
increase, imports decrease and the current account balance improves. The second is that the country’s output
decreases. Exports, which depend on what happens in
the rest of the world, may remain the same, but imports
come down with output and the current account balance
Unfortunately, the evidence is that the second mechanism has played the dominant role so far.
Per cent of GDP
Euro periphery current
account deficits since 2000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Given that these countries are members of the euro
area, they could not rely on an adjustment of the nominal exchange rate to become more competitive, at least
vis-à-vis their euro partners. They had to rely on a decrease
in wages and prices, and this has proven to be slow and
difficult (see Chapter 20).
Instead, much of the adjustment has taken place through
a decrease in imports, triggered by a decrease in output, an
adjustment known as import compression. As shown in
Figure 18.8, this has been particularly true of Greece. The
figure shows the evolution of imports, exports and GDP in
Greece since 2000. All three series are normalised to equal
1.0 in 2000. Note first how much output has decreased,
by roughly 25% since 2008. Note then how imports have
moved in tandem with output, also decreasing by 25%.
And exports have not done well. After sharply decreasing
M18 Macroeconomics 85678.indd 379
in 2009, reflecting the world crisis and the decrease in
demand from the rest of the world, they have not yet recovered to their 2008 level.
In short, the disappearance of the current account
deficits in the euro periphery is, on net, largely bad news.
What happens to the current account next depends largely
on what happens to output. And this in turn depends on
where output is relative to potential output. If much of
the decrease in actual output reflects a decrease in potential output, then output will remain low and the current
account surplus will remain. If, as seems more likely, actual
output is far below potential output (if there is, in our earlier terminology, a large negative output gap), then unless
further real depreciation takes place, the return of output
to potential will come with higher imports and thus a likely
return to current account deficits.
380 EXTENSIONS The open economy
Index 2000 5 1
Imports, exports and GDP
in Greece since 2000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
18.5 Looking at dynamics: the J-curve
We have ignored dynamics so far in this chapter. It is time to reintroduce them. The dynamics
of consumption, investment, sales and production we discussed earlier are as relevant to the
open economy as they are to the closed economy (see Chapter 3). But there are additional
dynamic effects as well, which come from the dynamics of exports and imports. We focus on
these effects here.
And even these prices may adjust
Return to the effects of the exchange rate on the trade balance. We argued that depreciaslowly. Consider a depreciation in
tion leads to an increase in exports and to a decrease in imports. But this does not happen
the dollar. If you are an exporter to
overnight. Think of the dynamic effects of, say, a 10% depreciation in the pound.
the United Kingdom, you may want to
In the first few months following the depreciation, its effect is likely to be reflected much
increase your price less than implied by
the exchange rate. In other words, you
more in prices than in quantities. The price of imports in the United Kingdom goes up and
may decrease your mark-up to remain
the price of UK exports abroad goes down. But the quantity of imports and exports is likely to
competitive with your UK competiadjust only slowly. It takes a while for consumers to realise that relative prices have changed,
tors. If you are a UK exporter, you may
it takes a while for firms to shift to cheaper suppliers, and so on. So a depreciation may well
decrease your price abroad by less than
lead to an initial deterioration of the trade balance; e decreases, but neither X nor IM adjusts
implied by the exchange rate. In other
words, you may increase your mark-up. ➤ very much initially, leading to a decline in net exports X - IMe.
As time passes, the effects of the change in the relative prices of both exports and imports
become stronger. Cheaper UK goods cause UK consumers and firms to decrease their demand
for foreign goods; UK imports decrease. Cheaper UK goods abroad lead foreign consumers
and firms to increase their demand for UK goods; UK exports increase. If the Marshall–Lerner
condition eventually holds – and we have argued that it does – the response of exports and
imports eventually becomes stronger than the adverse price effect, and the eventual effect
The response of the trade bal- ➤ of the depreciation is an improvement of the trade balance.
ance to the real exchange rate: iniFigure 18.9 captures this adjustment by plotting the evolution of the trade balance against
tially X, IM unchanged, ε decreases
time in response to a real depreciation. The pre-depreciation trade deficit is OA. The depre1 (X - IM/e) e v e n t u a l l y , X
ciation initially increases the trade deficit to OB: e decreases, but neither IM nor X changes
increases, IM decreases, ε decreases
right away. Over time, however, exports increase and imports decrease, reducing the trade
1 ( X - IM/e) increases.
deficit. Eventually (if the Marshall–Lerner condition is satisfied), the trade balance improves
beyond its initial level; this is what happens from point C on in the figure. Economists refer to
this adjustment process as the J-curve, because – admittedly, with a bit of imagination – the
curve in the figure resembles a ‘J’: first down, then up.
In general, the econometric evidence on the dynamic relation between exports, imports
and the real exchange rate suggests that in all OECD countries, a real depreciation eventually leads to a trade balance improvement. But it also suggests that this process takes some
M18 Macroeconomics 85678.indd 380
Chapter 18 The goods market in an open economy 381
Net exports, NX
A real depreciation leads initially to a
deterioration and then to an improvement of the trade balance.
time, typically between six months and a year. These lags have implications not only for
the effects of a depreciation on the trade balance, but also for the effects of a depreciation
on output. If a depreciation initially decreases net exports, it also initially exerts a contractionary effect on output. Thus, if a government relies on a depreciation both to improve
the trade balance and to expand domestic output, the effects will go the ‘wrong’ way for a
while. For example, the importance of the dynamic effects of the real exchange rate on the
trade balance were seen in the United Kingdom in the mid-1990s: Figure 18.10 plots the
UK trade deficit against the UK real exchange rate from 1990 to 2005. Two facts are clear:
Movements in the real exchange rate were reflected in parallel movements in net exports.
The appreciation was associated with a large increase in the trade deficit, and the later
depreciation was associated with a large decrease in the trade balance.
There were, however, substantial lags in the response of the trade balance to changes in
the real exchange rate. The dynamics of the J-curve were very much at work during this
Trade balance (£ billion)
Sterling index (1990 5 100)
Sterling exchange and the balance of trade in goods
M18 Macroeconomics 85678.indd 381
382 EXTENSIONS The open economy
18.6 Saving, investment and the current
You saw earlier how we could rewrite the condition for equilibrium in the goods market as
the condition that investment was equal to saving – the sum of private saving and public saving (see Chapter 3). We can now derive the corresponding condition for the open economy,
Getting there involves some manipulations, but do not worry; the end result ➤ and you will see how useful this alternative way of looking at the equilibrium can be.
Start from our equilibrium condition:
Move consumption, C, from the right side to the left side of the equation, subtract taxes,
T, from both sides, denote net exports (IM/e + X) by NX to get:
Y = C + I + G -
Y - T - C = I + (G - T) + NX
Recall that, in an open economy, the income of domestic residents is equal to output, Y,
plus net income from abroad, NI, plus net transfers received. Denote these transfers by NT
and add NI and NT to both sides of the equation:
(Y + NI + NT - T) - C = I + (G - T) + (NX + NI + NT)
Note that the term in brackets on the left is equal to disposable income, so the left side is
equal to disposable income minus consumption (i.e. saving, S). Note also that the sum of net
exports, net income from abroad and net transfers on the right side is equal to the current
account. Denote the current account by CA and rewrite the previous equation as:
S = I + (G - T) + CA
Commentators often do not make a
distinction between the trade balance
Rearrange the equation to read:
and the current account balance. This is
CA = S + (T - G) - I[18.5]
not necessarily a major crime: because
net income and net transfers typically
The current account balance is equal to saving – the sum of private saving and public savmove slowly over time, the trade and
ing – minus investment. A current account surplus implies that the country is saving more
the current account balances typically
move closely together.
➤ than it invests. A current account deficit implies that the country is saving less than it invests.
One way of getting more intuition for this relation is to go back to the discussion of the
current account and the capital account (in Chapter 17). There we saw that a current account
surplus implies net lending from the country to the rest of the world, and a current account
deficit implies net borrowing by the country from the rest of the world. So consider a country
that invests more than it saves, so that S + (T - G) - I is negative. That country must be
borrowing the difference from the rest of the world; it must therefore be running a current
account deficit. Symmetrically, a country that lends to the rest of the world is a country that
saves more than it invests.
Note some of the things that equation (18.5) says:
An increase in investment must be reflected either in an increase in private saving or public
saving, or in a deterioration of the current account balance – a smaller current account
surplus, or a larger current account deficit, depending on whether the current account is
initially in surplus or in deficit.
A deterioration in the government budget balance – either a smaller budget surplus or a
larger budget deficit – must be reflected in an increase in private saving, or in a decrease
in investment, or else in a deterioration of the current account balance.
A country with a high saving rate (private plus government) must have either a high
investment rate or a large current account surplus.
Note also, however, what equation (18.5) does not say. It does not say, for example,
whether a government budget deficit will lead to a current account deficit, or instead to
an increase in private saving, or to a decrease in investment. To find out what happens in
response to a budget deficit, we must explicitly solve for what happens to output and its
M18 Macroeconomics 85678.indd 382
Chapter 18 The goods market in an open economy 383
components using the assumptions that we have made about consumption, investment,
exports and imports. That is, we need to do the complete analysis laid out in this chapter. Using only equation (18.5) can, if you are not careful, be very misleading. To see how
misleading, consider, for example, the following argument (which is so common that you
may have read something similar in the newspapers): ‘It is clear the United Kingdom cannot
reduce its large current account deficit through a depreciation.’ Look at equation (18.5). It
shows that the current account deficit is equal to investment minus saving. Why should a
depreciation affect either saving or investment? So how can a depreciation affect the current
The argument might sound convincing, but we know it is wrong. We showed that a depreciation leads to an improvement in a country’s trade position and by implication, given net
income and transfers, an improvement in the current account. So what is wrong with the
argument? A depreciation actually does affect saving and investment. It does so by affecting the demand for domestic goods, thereby increasing output. Higher output leads to an
increase in saving over investment or, equivalently, to a decrease in the current account
A good way of making sure that you understand the material in this section is to go back
and look at the various cases we have considered, from changes in government spending, to
changes in foreign output, to combinations of depreciation and fiscal contraction, and so on.
Trace what happens in each case to each of the four components of equation (18.5): private
saving, public saving (equivalently, the budget surplus), investment and the current account
balance. Make sure, as always, that you can tell the story in words.
Let us end the chapter with a challenge. Assess the following three statements about the
US trade deficit – the largest by far in the world – and decide which one(s) is (are) right:
Suppose, for example, that the government wants to reduce the current
account deficit without changing the
level of output, so it uses a combination
of depreciation and fiscal contraction.
What happens to private saving, public
saving and investment?
The US current account deficit shows that the US is no longer competitive (see Chapter 17). It is a sign of weakness. Forget saving, or investment. The United States must
urgently improve its competitiveness.
The US current account deficit shows that the United States just does not save enough to
finance its investment. It is a sign of weakness. Forget competitiveness. The United States
must urgently increase its saving rate.
The US current account deficit is just a mirror image of the US capital account surplus.
What is happening is that the rest of the world wants to put its funds in the United States.
The US capital account surplus and, by implication, the US current account deficit are in
fact a sign of strength, and there is no need to take policy measures to reduce it.
In an open economy, the demand for domestic goods is
equal to the domestic demand for goods (consumption,
plus investment, plus government spending) minus the
value of imports (in terms of domestic goods), plus exports.
In an open economy, an increase in domestic demand
leads to a smaller increase in output than it would in a
closed economy because some of the additional demand
falls on imports. For the same reason, an increase in
domestic demand also leads to a deterioration of the
An increase in foreign demand leads, as a result of
increased exports, to both an increase in domestic output
and an improvement of the trade balance.
Because increases in foreign demand improve the trade
balance and increases in domestic demand worsen the
trade balance, countries might be tempted to wait for
M18 Macroeconomics 85678.indd 383
increases in foreign demand to move them out of a recession. When a group of countries is in recession, coordination can, in principle, help their recovery.
If the Marshall–Lerner condition is satisfied – and the
empirical evidence indicates that it is – a real depreciation leads to an improvement in net exports.
A real depreciation leads first to a deterioration of the
trade balance and then to an improvement. This adjustment process is known as the J-curve.
The condition for equilibrium in the goods market can
be rewritten as the condition that saving (public and
private) minus investment must be equal to the current
account balance. A current account surplus corresponds
to an excess of saving over investment. A current account
deficit usually corresponds to an excess of investment